Portfolio Rebalancing

The need to rebalance a portfolio effectively is one of the critical responsibilities of sophisticated asset management. All investment strategies must be rebalanced periodically, as the portfolios drift from their optimal allocations. The question is: what criterion should be used to decide when to rebalance?

Unfortunately, a rigorous basis for defining portfolio rebalancing has been an open question for over 50 years. Portfolio rebalancing has been based largely on ad hoc criteria with little theoretical or empirical justification. Rebalancing rules in practice are frequently calendar based; e.g., monthly, quarterly, or annually. Alternatively, managers employ range rules and rebalance the portfolio when an asset drifts outside of a prescribed range relative to optimality. Such rules are often ineffective.

Effective Rebalancing requires a measure of statistical significance to determine whether the optimal portfolio is different from the current portfolio in terms of likely performance in the investment period. Following a signal based on such a measure avoids the costs of unnecessary trades while indicating a rebalance when there is statistical evidence for its benefit.

Michaud optimization provides the statistical framework for creating a rigorous procedure for portfolio rebalancing. Our patented rebalancing test determines whether or not a significant difference exists between the selected portfolio on the efficient frontier and the current holdings relative to likely performance. This need-to-trade test prevents ineffective and costly trades while enhancing investment value.